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It's Good to be Bad

In this week's FinMail we discuss and understand Bad Banks - the plausible solution to the problems of NPA.





The Story:


Indian Banking Sector has long been in shackles due to its everlasting problem of NPAs. And in this year's budget, the FM reintroduced the concept of Bad Banks - the supposed solution to the problem of the Indian banking Industry. Last week, Banks submitted their reports to the Indian Banking Association, consisting of the identification of large defaulted loans, ideally loans that are more than ₹500 Crore each and have been categorised as defaulted loans. The plan is to sell these loans to the bad banks (sell these loans, yes. Don't worry we will get there) The loans submitted by these banks totaled around ₹2 lakh crore which has been laying around as NPAs in the books of the banks. With the sale of the defaulted loans the banks will take a breath of relief as the bad banks are supposed to take the troubles of these banks. But before we move on with the Bad Banks, let us catch up with the current NPA Situation in the Indian Banking Industry.


The Current Banking and NPA Situation:


Indian Banks have been in the shackles of their NPA for decades and it is choking them. The rising numbers of NPAs are a big pain for the banks. The data suggests that the gross NPAs stood at 7.5% of the total loan amounts of the banking sector in September 2020. These numbers are expected to rise to at least 13.5% by this September due to Covid related problems. The real number can be more too. And that's just not it. In the past 10 years, Indian Banks have written off (basically forgotten) loans worth around ₹8,83,168 Crores till FY20, 75% of which have been written off by Public Sector Banks & in FY21 alone, banks had to write off another ₹1,15,038 crore in the first 3 quarters It is evident that NPAs and Public Sector Banks have a never-ending love tale; one-sided though.


How do NPAs harm banks?


There's no argument that NPAs hurt the progress of the banks. How? One is that as the loans that do not perform i.e. loans that don't get paid back, the lending capital that the bank has, decreases. And because of it, banks would not be able to lend more to earn more. In this situation, they'll need to raise more capital which than the investors to provide for because of NPAs. The cost of raising more capital would be costly due to the same. The profitability would also take a toll and so would the reputation.


But why Bad Banks?


It is pretty clear that NPAs are not good for banks. So if a bank has rising NPAs, it can't function properly as it has to conduct profitable business on the front end and work to recover its NPAs on the other. Talking about recoveries of NPAs, Public Sector Banks were only able to recover ₹45,659Crore out of the ₹4,32,584 Crore that they had written off in the years 2015-16 to 2018-19. So the banks were only able to recover 10% of the loans. So in the job of recoveries too, banks are clearly not efficient. But what if there was someone who agrees to take out the bad stuff for you and left you with the good stuff so that you can focus on your job and do that one single thing correctly?

You'd agree instantly, right?


And that is where the hero drops in, (drumroll please) BAD BANKS


What are Bad Banks?


Bad Banks being called Bad Banks is the same way how we call the Sanitation Workers, "Kachrawalas" even though they are the ones who clean the mess. Bad Banks too in reality are not Bad Banks but the banks who clean the bad loans of the other banks.


In reality, they function just like Asset Reconstruction Companies (ARCs) who have only one job - Recover the Assets. Sounds dope? In reality, it is a tough job to do and also the reason why our government wants Bad Banks to do the jobs and not the regular banks that we visit. In technicalities they are ARCs but the name Bad Banks as the name has some coolness attached with it.


These 'Bad Banks' are set up with the sole purpose to recover the loans that are defaulted. These banks start with defaulted loans as their assets and they recover these loans. Just for understanding, consider Vasuli Bhai who has the sole objective to recover money from those who have taken a loan from his boss. These borrowers are usually not able to pay their loans after borrowing and hence Vasooli Bhai is appointed to recover the money from the borrowers. Bad Banks are just like Vasooli Bhai but in a good way. They do things in the right way. They try to recover the money by bringing the loan defaulters against the law.


Bad Banks purchase the bad loans or the NPAs from the banks and pay them a proportionate amount (let's say 60%) The banks would anyway agree to take 60% of the amount and forego the 40% as they would never be able to recover it themselves fully. So if the NPA stands at ₹4,000 Crores, the bad banks would purchase the loan from the bank for ₹2400 Crores and pay the bank. Now the Bad Bank now has the task to recover this bad loan as it is the Bad Banks responsibility now.


But what do these Bad Banks get in return?


The Bad Loans are now the responsibility of the Bad Bank and thus whatever amount they are able to recover from the loan defaulters, it is the earnings of the Bad Bank. Sometimes they are able to recover more than they have paid to the banks so they are in profits. Sometimes they are not able to recover it fully, which is the loss for the bad banks. But as Profits and Loss each form a part of a business, these bad banks are okay with these risks. The main objective is not to earn Profits but to recover as much as possible and if in that pursuit, the bad banks earn profits, then it is like a cherry on the cake.


The question that might have come across your mind is that if Bad Banks are the solution to the problems of NPA then why so long to introduce this?


Well, the idea of creating a bad bank to clean up the mess in the banking industry is not a newly brought up concept but Creating ARCs or Bad Banks has been been in the conversation since 2016 (as far as we know it).


But it was not considered before as a viable alternative until there were no other choices left. And as the Covid hit, NPAs are going to the rooftop. And that's bad news for the government. Because if a Public Bank has to write off a loan as bad debt, the government will need to put in the capital in these banks to keep the banks running and definitely the government doesn't want to keep doing this. And also the concept of Bad Bank is not new. USA had introduced this concept in the year 1988 after which many countries like Sweden, Germany and France had followed it. But these banks or ARCs haven't much made a huge impact. But yet here they are.


The Bad in the Bad Banks:


Are Bad Banks in India really feasible? Former RBI Governor Raghuram Rajan had opposed the idea of setting up a bad bank in which banks hold a majority stake. “I just saw this (bad bank idea) as shifting loans from one government pocket (the public sector banks) to another (the bad bank) and did not see how it would improve matters. Indeed, if the bad bank were in the public sector, the reluctance to act would merely be shifted to the bad bank,” Rajan wrote in his book I Do What I Do.


The success of these Bad Banks depends on how the plan is executed and how motivated the bankers are to reduce their bad assets from their books. Because as the bad banks are created for the sole purpose to clean the mess, there doesn't mean the mess wouldn't be created. Of course, the goal is to reduce stress by reducing the NPAs. But there lies the moral of the bankers whether they would want to reduce them or not. In the countries where these Bad Banks were created, they have ended in encouraging more reckless lending. And here too, the risk remains the same.


The core structure of the bad banks doesn't motivate the banks to give out more safe loans but instead, it encourages the banks to give out more loans recklessly without caring about the risks as there is always someone ready to clean up your mess.


That is it for this week's FinMail. Keep learning, Stay safe. And we will see you in the next week.

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